Evans Says Fed Must Guard Against 'Cost' of Bigger Housing Drop

By Vivien Lou Chen and Steve Matthews
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Oct. 23 (Bloomberg) -- Federal Reserve Bank of Chicago President Charles L. Evans said policy makers must shield the economy from ``high cost'' events such a worsening housing slump.

``I do not see this extreme outcome as likely,'' Evans said yesterday in his first speech on the economy as a policy maker. Still, ``it is one of those high cost outcomes that we should guard against,'' while closely monitoring inflation, he said at the University of Chicago's Graduate School of Business.

Evans, who votes on interest rates this year, stressed the importance of ``risk management'' in determining Fed policy and noted that ``uncertainty'' about the impact of financial volatility has increased in the past week. Traders anticipate the Fed will lower rates for a second time on Oct. 31, and Evans didn't rebuff those expectations.

``To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk- management considerations have an important role in the current policy environment,'' said Evans, 49, who became president of the Chicago Fed on Sept. 1. Falling home sales and values may pose ``a more serious downside risk to growth'' than policy makers expect.

Housing starts in the U.S. plunged more than forecast to a 14-year low in September, dropping 10.2 percent to an annual rate of 1.191 million from 1.327 million the prior month. Higher mortgage costs and stricter lending rules may further depress home sales and feed the decline in construction that threatens to stall economic growth.

Construction Jobs

The lack of job losses in construction has been ``surprising,'' Evans said in response to a question after the speech. While some workers fired from residential projects may have switched to commercial assignments, that explanation ``still seems unsatisfying,'' he said. Evans projected more firings in construction will take place.

The Fed lowered its benchmark interest rate by a half point to 4.75 percent on Sept. 18, the first cut in four years, to protect the U.S. from sinking into a recession sparked by fallout from the housing-market collapse. Trading in federal funds futures indicate an 86 percent chance of another cut, to 4.5 percent, when policy makers meet again next week.

Prices paid by U.S. consumers rose more than forecast in September as food and energy costs climbed, while the core measure that excludes those items showed inflation remains contained.

`Optimistic' on Inflation

``Although I am optimistic about the chances for further inflation improvements, I would see any increase in inflation or inflation expectations from their current levels as a serious concern,'' Evans said. The central bank can't be ``lax on inflation front,'' and must carefully monitor both the outlook for prices and growth.

The U.S. economy expanded at the fastest pace in more than a year during the second quarter, before the sell-off in credit markets that threatens to hobble growth in the second half. Gross domestic product rose at a 3.8 percent annual rate from April though June, propelled by a surge in exports.

Since August, growth in five of the Fed's 12 regional districts has slowed, lending weight to the case for further interest-rate cuts to cushion the economy from housing and financial-market turmoil. Consumer spending, manufacturing and service industries weakened as the ``pace of growth decelerated'' across the U.S., the central bank said in its regional business survey last week.

`Soft' Economy

Economic growth will be ``soft'' in coming months and recover later next year, moving closer to its potential rate of above 2.5 percent, Evans said. The Chicago Fed board was one of five regional bank boards that opposed the central bank's decision to lower the so-called discount rate by half a percentage point. The discount rate is the rate charged for direct loans to banks.

``Going forward, policy and the economic outlook have to be mindful'' about whether financial markets are functioning efficiently and effectively, Evans said in response to another audience question. ``Actions to date have been completely appropriate.''